• Managing Insider Trading Risk - Yes, Martha's Back, but She Did Trade and She Did Go to Prison!
  • March 25, 2005 | Author: T.J. (Mick) Grasmick
  • Law Firm: Manatt, Phelps & Phillips, LLP - Los Angeles Office
  • The Martha Stewart case underscores the public's notion that it is the corporate elite who can bring ill repute and possibly destroy a company by illegal insider trading. However, companies that do not have adequate insider trading policies and procedures in place for all employees risk the same potential fate. Both public companies and companies that are not subject to the Sarbanes Oxley Act of 2002, but are still subject to the insider trading laws, customarily concentrate their attention to insider trading on director and executive compliance. Insider trading compliance requires training and controls that cover all employees and not just the board of directors and senior management insiders. Corporate counsel may need to review and revamp employee handbooks, training, internal controls and audits for non-executive employees in order to adequately manage the reputation and strategic risks posed by insider trading abuse. Inadequate compliance and inattention to the risks of illegal insider trading throughout the organization could lead to corporate responsibility in shareholder litigation for failing to monitor potential employee insider trading activities. There is further risk to the corporation if it should be subject to the severe penalties of the federal sentencing guidelines in a criminal prosecution and has an inadequate insider trading compliance program.

    A Primer on Insider Trading

    Insider trading refers to unlawful trading by persons who possess material, non-public information about a company whose shares are traded. If knowledge of the information would affect a decision to buy or sell and the information has not been publicly disclosed, it is material inside information. Common examples are pending acquisitions, unexpected financial results and significant adverse product developments or litigation. The federal and state statutes prohibiting insider trading are not limited to trades of only the insider's company stock nor need the company's stock be publicly traded. Most SEC enforcement actions are based on director or senior executive profit taking by their own trading on their company's secret information or by "tipping" this information to cohorts. Court decisions have established two theories of insider trading liability: (i) directors and officers have a fiduciary duty to shareholders to disclose any material inside information they possess or abstain from trading; and (ii) anyone entrusted by a company with insider information commits a fraud on the company if they misappropriate the information for profit. The latter theory would apply to non-executive employees throughout an organization who may become privy to material inside information in the normal course of their employment.

    The elements of illegal insider trading can be difficult to apply. For example, some may question the harm portrayed in the movie The Big Chill when the company executive gratuitously tips his down-and-out friend about the unannounced sale of the family business to a public conglomerate. Others may ponder why a messenger who picks up confidential merger documents entrusted to him cannot trade on the information contained in the envelope but the same messenger would be free to call his broker if he overhears lawyers on the elevator discussing another unannounced acquisition. While the SEC alleged that Martha Stewart's broker tipped her of insider trades at ImClone, she was not prosecuted for insider trading, possibly because the judicial theories of liability were not clearly applicable to the facts in her case.

    When illegal insider trading is discovered, the financial, social and criminal penalties for individuals can be stiff: disgorgement of all gains (or losses avoided), treble that amount in fines, a prohibition on being a director of any other public company, and possible criminal prosecution. There is also potential civil and possibly criminal exposure for employers who do not take sufficient steps to prevent employees from illegal trading on insider information.

    Insider Trading Policies and Practice

    Most companies have insider trading policies that summarize the prohibitions and possible penalties for improperly disclosing or profiting from company or customer material, non-public information. These are predominantly distributed to executive officers and directors to guide the performance of their duties and obligations to the company. Designated insiders of public companies (generally executive officers, directors and 10% or larger shareholders) are also routinely apprised and assisted with their reporting duties under the Securities Exchange Act of 1934, and when they may trade and when they may not, such as during set "blackout periods" before financial results are public.

    By contrast, insider trading compliance is often not covered in detail in employee handbooks or ethics codes, and training and auditing often is not well documented. Employees may receive an ethics code that generally prohibits the disclosure or use of any confidential and proprietary company information for personal gain, but the principles and penalties of the insider trading laws and the reach of "tippee" liability often are not included. In addition to employees trading illegally on the employer's stock, corporations must consider the risks that employees may misuse confidential customer information or that employees of the company's service providers and vendors could misuse confidential information made available to them by the company. Hence vendor policies, training, internal controls and audits are important.

    It may soon be a best practice standard to require the pre-clearance of all trades or exercises of any stock options by all employees (not just executives and directors) and to require both new employee and annual all-hands refresher training sessions on insider trading. Staff assigned to confidential projects, such as due diligence teams, should be reminded of the company's insider trading policy.

    Controls and internal audits should apply throughout the organization to monitor both executive and non-executive employee trades in company stock, and trades in the stock of customers as well. A company should review its vendors and outside service providers' insider trading policies with respect to the confidential information that may be shared by the company and obtain these parties' written agreement to abide by the company's vendor policies.

    Corporate Exposure

    A company that recklessly disregards the risk that its employees could engage in illegal trading can also face insider trading liability for its failure to supervise its employees. If a company has a woefully inadequate internal system for controlling access and use of confidential information and fails to educate and train its employees, that reckless disregard of insider trading risks could be very costly financially and in damage to reputation. Costly class actions would surely arise should insider trading suspicions surface after a public offering.

    Reckless corporate disregard for a company's exposure to insider trading is subject to potential prosecution for corporate criminal liability. However, under the Federal Sentencing Guidelines an effective organizational compliance and ethics program will mitigate potential corporate fines and conditions of probation for criminal corporate conduct.


    Companies and corporate counsel should ensure that insider trading compliance goes beyond executive insiders and addresses the broad risks to the organization of illegal insider trading by any employee, as well as by vendors. Martha Stewart may recover her reputation, but her company's stock price languishes as a result of her insider trading scandal. Immediate and long-term investor and shareholder ire is a greater risk in the post-WorldCom and Enron era, and class actions are likely against public companies with insider trading compliance and risk management shortcomings that result in serious damage to the reputation and market price of the company's stock.